By Jerome Tse, Amanda Kazacos and John Boyagi, King & Wood Mallesons
While the ATO has understandably been occupied with implementing the government’s COVID-19 measures, the release of this draft ATO guidance (concurrently with the release of Taxation Ruling TR 2020/4 and accompanying Practical Compliance Guideline PCG 2020/7 in relation to the arm’s length debt test for thin capitalisation purposes) suggests that the ATO has started to reengage with core taxation matters — particularly those relevant to large corporates and multinational enterprises.
Practical Compliance Guideline PCG 2017/4 — a refresher
The PCG assists taxpayers in determining the risk rating of their financing arrangement entered into with related parties and to which the cross-border test under Subdiv 815-B ITAA 1997 applies. The PCG requires businesses to apply two tables to determine their risk rating (and the ATO’s compliance approach will vary depending on the risk rating):
a pricing risk scoring table comprising of indicators including:
- whether the arrangement has appropriate collateral, is subordinated or has “exotic features”
- a comparison of the all-in cost of the actual arrangement compared to the cost of referrable third-party debt
- whether the operating and financing currencies match, and
- the sovereign risk of borrower (for outbound loans), and
- a motivational risk scoring table comprising indicators including:
- the leverage of borrower
- the tax rate in the lender’s jurisdiction
- the interest cover ratio, and
- whether the arrangement involves hybrids or is covered by a taxpayer alert.
Once the scores for the above tables have been compiled, the taxpayer’s risk rating can be identified through the below matrix.
Broadly, a low-risk rating will mean that the ATO will generally not apply compliance resources to examine the tax outcomes of the related party financing arrangement. The ATO’s activities will be focused on verifying the accuracy of the rating. Higher risk ratings will increase the likelihood that the ATO will review or audit the taxpayer. At the highest risk rating (the “red” category), litigation is a significant risk and the ATO will not consider entering into an advanced pricing agreement with the taxpayer.
Draft “Schedule 3”
One of the key messages of Sch 3 is that an interest-free outbound loan is viewed as high risk by the ATO unless mitigating factors exist to reduce the rating. In particular, Sch 3 provides that an interest-free outbound loan to a related party provides a base pricing risk score of 10 (placing the pricing risk score in the “amber”/high-risk zone). The mitigating factors outlined in the Schedule are where:
- a zero-interest rate is an arm’s length condition of the loan (for example, it might be reasonable for a foreign subsidiary engaging in early-stage mining exploration or prospecting to borrow from its Australian parent at zero-interest, noting that third-party lenders are less likely to lend to an early-stage mining entity with little cash flow and/or security)
- the loan is in substance an equity contribution, or
- independent entities would not have entered into the actual loan and would have entered into an equity funding arrangement.
Conversely, an interest-free inbound loan will start off with a base pricing risk score of zero.
Schedule 3 also continues the emphasis within PCG 2017/4 that evidence to support positions taken will be critical. In our experience, objective factual evidence gathered at or near the commencement of the loan is generally more reliable, easy to obtain and persuasive in the event of a later audit. Depending on the quantum of the loan, businesses may also consider obtaining contemporaneous economic/pricing evidence at the same time.
The Commissioner provides guidance on what he considers should be evidenced in showing that a loan is in substance an equity contribution or an equity funding arrangement (ie to assist in determining whether the mitigating factors in (b) or (c) above are present). The Commissioner considers this will be satisfied if at least one of items 1 and 2 below and at least one of items 3 and 4 below are satisfied (the Equity Matrix):
- the rights/obligations of the lender are effectively the same as the rights and obligations of a shareholder (eg voting rights or returns dependent upon profits) OR
- the parties had no intention of creating a debt (with a reasonable expectation of repayment) and therefore there was no intention of creating a debtor–creditor relationship — importantly, note the criteria is framed in the negative AND
- the parties’ intentions are that the funds would only be repaid (or interest imputed) where the borrower is in a position to repay OR
- the borrower has questionable prospects of repayment and is unable to borrow externally. In determining whether funds might have been borrowed from an independent lender, the industry’s funding practices, the business activity of the borrower and financial position of the borrower should be reviewed.
The ATO provides four examples in four different industries to illustrate whether the Equity Matrix would be satisfied (ie the loan would be considered an equity contribution) such that the “amber” base pricing risk score (of 10) would be reduced to the “blue” pricing risk score (of three). Whilst there are common themes across the four examples, some industry-specific factors within each example are worth highlighting.
Mining: The ATO acknowledges that foreign investment restrictions may prevent an Australian parent from injecting capital into a foreign subsidiary. This by itself will not result in the loan being seen as an equity contribution.
Manufacturing: If a borrower has a healthy financial position and good creditworthiness, the arrangement would more likely be seen as a debt interest, especially if an independent lender would have charged interest.
Infrastructure: It is commonplace for funds to be lent by a parent to a subsidiary in the infrastructure sector on an interest-free basis to fund long-term assets, which are repayable once the infrastructure asset becomes cashflow positive many years later. The ATO acknowledges that these factors would assist in characterising the arrangement as an equity contribution.
Commercial property management: The assessment under Sch 3 is required at the time the arrangement is entered into. Granting an interest-free holiday period to a subsidiary after the arrangement is entered into will not change whether the loan should now be seen as an equity contribution. However, evidence may be adduced that arm’s length lenders would have entered into such an interest moratorium to demonstrate a nil interest rate as being an arm’s length condition.
Schedule 3 also highlights the relevance of group treasury policies to help inform whether actual terms and conditions are reflective of arm’s length terms and conditions. In our experience, historical treasury policies are difficult to obtain many years later, especially as group treasurers have often moved on or retired. Capturing such policies contemporaneously is recommended.
In summary, we would encourage all taxpayers to keep contemporaneous evidence to support the rationale for entry into such an arrangement, including the reasons for choosing to lend/borrow on an interest-free basis, especially when the position adopted is that the arrangement is akin to an equity contribution.
Source: This article was originally published on the King & Wood Mallesons website, 20 August 2020, and has been reproduced with permission.